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The story of the Emperor’s New Clothes, by Hans Christian Anderson, is one of the most famous tales ever told, a timeless allegory with lessons for young and old alike. The story goes something like this … two weavers promise to make an Emperor a splendid new suit of clothes that they say will be invisible to those who are either unfit for their job or unusually stupid. In an act of supreme self-aggrandizement the Emperor orders a new suit from the weavers; which his trusted advisers all agree is of exceptional quality. The denouement involves the Emperor parading before his subjects, but no one dares to state the obvious for fear of being regarded as stupid. Finally, an innocent child cries out, "But he hasn’t got anything on!"

We think this story provides some compelling lessons for today’s investors in financial markets.

Overconfidence

In ages past there was an Emperor who was obsessed with new clothes and so spent all his wealth on making sure he was well dressed. He did not care about inspecting his soldiers, going to the theatre or going out unless it was to show off his new clothes.

Who is most affected in financial markets? All market participants

The overconfidence (and overoptimism) bias refers to people’s tendency to exaggerate their own abilities, resulting in people being negatively surprised more often than they expect. This bias is particularly prevalent when people suffer from an illusion of control, or when they become so called “experts”. One study1 found that 74% of fund managers believed themselves to be above average at their jobs! Of the remaining 26%, most thought they were at least average. One example that we come across in financial markets is the tendency for investors to form overly optimistic views about growth companies and overly pessimistic views about value companies.

Principal-agent problem

“I’ll send my faithful old minister to the weavers,” said the Emperor to himself. “He is my most wise and trusted servant and will be the most able to tell me how the material looks"

Who is most affected in financial markets? Anyone in a fiduciary relationship.

When a principal hires an agent to carry out specific tasks, the hiring is termed a "principal-agent” relationship. In the story, the Emperor asks the honest old minister to opine on his new suit and receives very positive feedback. But a principal-agent conflict has been created because the minister worries that he’ll lose his job if he admits he can’t see the fabric. The most obvious example in financial markets is the conflict between the managers of a company (agents) and the shareholders of the company (principals). Low quality management can often be accused of being more concerned with personal advancement rather than stewards of shareholder capital.

Loss aversion

The Emperor gave each of the tricksters a cross to wear in his buttonhole, and the title of "Sir Weaver."

Who is affected in financial markets? Professional investors.

In the story, the Emperor begins to suspect that he has made a bad mistake but he can’t quite bring himself to admit it. Instead he compounds his error by giving the weavers more money, and he even furnishes them with gifts! It’s a bit like doubling up on a losing bet. In investing, the temptation to hold onto a losing position is a strong one, in the hope that it will somehow recover and confirm that you were right in the first place. As Robert Shiller of Nobel prize fame explains, “People who refuse to sell when they have made a loss on a stock are trying to avoid regret. Realising a loss brings on the regret. People will go to extraordinary lengths to avoid this even if it means taking even bigger risks.”

Herding

The whole population lined the streets and said, "Oh, how fine are the Emperor's new clothes! Aren’t they a perfect fit? Look at his long train!" Nobody would confess that he couldn't see anything, for that would suggest that they were either unfit for their position or, indeed, a fool.

Who is affected in financial markets? Anyone who makes forecasts, such as sell-side analysts.

Herding behaviour simply refers to the human desire to conform to the crowd. Looking for safety in numbers is a useful survival instinct but it can supress the power of individual thought which interferes with accurate forecasting. Sell-side analysts are often guilty here. When presented with new information, such as quarterly results, analysts tend to upgrade or downgrade forecasts in small increments so as not to stray too far from the consensus view. Once an analyst does move away from consensus, it is often the case that other analysts follow. For example, one study2 found an average 70% probability that one positive revision is followed by another.

Confirmation bias

"Well, I'm supposed to be ready," the Emperor said, and turned again to admire himself again in the mirror. "It fits me amazingly, does it not?" He intently studied and admired his costume.

Who is affected in financial markets? Everyone, but especially company management.

The confirmation bias is the tendency for us to search for and interpret information in a way that confirms our pre-existing beliefs. In financial markets, management teams usually attribute positive trading results to their own strategic decision making, whereas weak trading is usually a result of “market conditions” or some exogenous influence such as bad weather. We see lots of examples where company management stick to unrealistic profit guidance in the hope, rather than the expectation, that performance will subsequently improve. This behaviour usually leads to a series of disappointments or profit warnings as management slowly adjust to the reality of the situation.

What makes the Behavioural Finance Team at J.P. Morgan Asset Management different?

In the Behavioural Finance Team at J.P. Morgan Asset Management we believe that investors are driven by behavioural biases, such as those described above, which leads to a divergence between price and fair value. Our investment philosophy has this belief as its foundation stone.

Our investment process combines both quantitative and fundamental techniques, taking the best of both approaches whilst avoiding the behavioural pitfalls of each. We find a quantitative approach brings discipline and rigour to the common sense side of fundamental investing. For example, our decision making framework is extremely disciplined in order to overcome our own behavioural biases.

In the story of the Emperor’s New Clothes, the child who finally ousted the Emperor is the only character apparently not burdened by behavioural biases. In a powerful lesson to all the so called “experts” out there, the little child behaves like a true contrarian and has the power to change the consensus view.

"But he is as naked as a newborn!" the whole town cried out at last. The Emperor shivered, for he knew they were right. But he thought, "This procession has got to go on." So he walked more upright and proud than ever before, as his entourage held his invisible train high.

For Professional Clients/ Qualified Investors only – not for Retail use or distribution.

This document has been produced for information purposes only and as such the views contained herein are not to be taken as an advice or recommendation to buy or sell any investment or interest thereto. Reliance upon information in this material is at the sole discretion of the reader. Any research in this document has been obtained and may have been acted upon by J.P. Morgan Asset Management for its own purpose. The results of such research are being made available as additional information and do not necessarily reflect the views of J.P. Morgan Asset Management. Any forecasts, figures, opinions, statements of financial market trends or investment techniques and strategies expressed are unless otherwise stated, J.P. Morgan Asset Management’s own at the date of this document. They are considered to be reliable at the time of writing, may not necessarily be all-inclusive and are not guaranteed as to accuracy. They may be subject to change without reference or notification to you. Both past performance and yield may not be a reliable guide to current and future performance and you should be aware that the value of securities and any income arising from them may fluctuate in accordance with market conditions. There is no guarantee that any forecast made will come to pass.

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